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September 22, 2005

Bring it On! Algos and Soft Dollars Offer Clean Audit Trail

By Dave Leone

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  • Bring it On! Algos and Soft Dollars Offer Clean Audit Trail
  • Page 2

It seems that almost every discussion about equity trading these days turns to the topic of algorithmic trading and its impact on the securities industry. Buyside interest is brisk in this once exotic mathematical form of trading. Moreover, algorithmic trading seems to be the catch-all topic, or proxy discussion, for the many changes occurring in equities: the rapid growth of electronic trading, including DMA; the reduction of spreads and commissions; and the change in the nature of the buyside-sellside relationship.

Despite predictions of a near wholesale conversion to electronic trading, two questions remain: Will the buyside actually use these tools to the extent that many predict? And what will drive that usage?

Currently, one estimate puts buyside-generated algorithmic trades at 11 percent of total volume, headed to 17 percent by 2007. The most common reasons attributed to this rise are a desire for greater anonymity, cheaper trades and better execution quality.

A Buyside Ceiling

Interestingly, some buyside firms say they've already reached a ceiling in the amount of electronic trading. Will this continue to be the case, and have any growth factors been left out?

I believe one little-discussed factor that could spur additional growth of algorithmic trading on the buyside is soft dollars.

This notion runs contrary to conventional wisdom, with industry analysts predicting sharp reductions in the use of soft dollars. But the use of soft dollars has not abated, and for a very pragmatic reason: The buyside still uses sellside research, and often times lots of it.

And with the gradual automation of soft-dollar workflows, regulatory and plan sponsor scrutiny of execution costs-combined with the need to pay for research-buyside traders may, in time, find electronic trading a clean solution to an administrative headache.

It's been a rocky few years for soft dollars, but the clouds seem to be parting. Recent language from both the SEC and Britain's FSA indicate that, rather than ban the practice, as some predicted only a year ago, it will survive. There will be stricter definitions about what constitutes "research." Both regulatory bodies also will encourage more transparency in the process, beginning with execution right through to the payment of bills.

There are a number of reasons why both regulatory authorities appear to be arriving at the same conclusion. But the main catalyst seems to be encouraging "independent research." This has been a prominent goal of regulators and prosecutors in the post-bubble era. Yet, despite hopes to the contrary, investment managers have not embraced the practice of writing hard-dollar checks for research to any meaningful degree.

The signals from the regulators were clear: With no soft dollars, a true independent research community would be at risk

Difficult Work

Managing a soft dollar program can be an onerous task. It doesn't receive near the attention that algorithms do. Managing a soft dollar program is a consuming endeavor: From the proxy votes on whose research to acquire, to tracking trade commissions by broker, right through to managing the payment process. In fact, many buyside trading decisions are driven as much by "administrative needs" as they are by best execution.